GDI and the terms of trade revisited

In an earlier post, I explained at great length how the collapse of commodity prices led to a sharp deterioration of Canada's terms of trade, and I concluded that this was the real story of why Canada was in recession:

Over the past weeks and months, there have been any number of articles about how and why Canada fell into recession. But the real story has little to do with declines in housing prices or consumer debt loads. It's all about the terms of trade.

Commodity prices have been trending upwards recently, so it's time to see what that implies for the prospects of a turning point.

Here is an updated version of the graph of how GDP and the terms of trade have contributed to GDI:

More than 70% of the reduction in GDI can be attributed to the deterioration in Canada's terms of trade, and the terms of trade are largely driven by commodity prices. But commodity prices seemed to have hit bottom. Here is what you get if you take the average of the Bank of Canada's commodity price indices for April and May and the first two weeks of June to calculate an estimate for 2009Q2:

This looks like yet another piece of evidence that we are at or near a turning point. Even if commodity prices don't go on a tear as they did in 2008, the free fall in the terms of trade seems to have stopped. It is reasonable to hope that the terms of trade will be making a positive contribution to GDI in 2009Q2.

Comments

[Nick Rowe]

That second graph surprised me. I hadn't realised just how much our terms of trade are driven by commodity prices.

But I wonder to what extend commodity prices drive our GDP? Eyeballing the first graph, it looks like there might be some connection, with terms of trade leading GDP, but it's not clear.

[Stephen Gordon]

Certainly things like fixed business investment would be affected by commodity prices - many investment projects in the tar sands were canceled or delayed when oil prices fall. And there are stories to the effect that some of that is coming back as well.

[Nick Rowe]

I keep thinking about James Hamilton's thesis, that high oil prices cause (US) recessions. I can't remember how much it was a theoretical vs an empirical thesis. But if high oil prices caused US recessions because the US imports oil, why shouldn't it cause a Canadian boom? Somehow, though I'm not sure exactly how, Canadian data ought to be able to shed some light either on the validity of his thesis, or else the mechanism through which it might operate.

[Patrick]

Inventory of Major Alberta Projects latest number:

May: $238791.3 x 10^6

Here are previous totals:

April: $234001.2 x 10^6
February: $261735.9 x 10^6
December: $270727.3 x 10^6
November: $279300.0 x 10^6
October: $286527.2 x 10^6

http://www.albertacanada.com/statpub/1112.html

[Patrick]

Nick, Looks to be a bit of both:

http://dss.ucsd.edu/~jhamilto/Hamilton_oil_shock_08.pdf

[MattM]

"That second graph surprised me. I hadn't realised just how much our terms of trade are driven by commodity prices."

Note that the two curves are on wildly different scales. Commodity prices are far more volatile than are labor prices or the price of capital goods so it stands to reason that the two curves would match up nicely once you matched the variances.

A change of 60% in commodity prices lines up with a change of 10% in terms of trade if I'm eyeballing it correctly. Seems reasonable to me.

[Stephen Gordon]

I had made that point in the 'beer and pizza' post. Commodities are still only a fraction of exports, but since theirs are the only ones whose relative prices vary to any extent, they drive movements in the terms of trade.

[MattM]

Well, then that means that I'm smart enough to be a professional economist instead of merely a professional physicist.

By the way, thank you both for your continuing blog posts. Always interesting, and to a significant extent have shaped my current political preferences and views on public policy (in addition to purely intellectual appreciation of econ stuff).